Finance Business

7 Most Important Financial Ratios for A Business

At times looking at the numbers on your financial statements can be an overwhelming experience. This is because a lot of information makes it difficult to decide which is the best measure for your business health. That is where the significance of understanding different financial ratios for your business occurs. This piece of writing aims to explain the 7 most important financial ratios for a business.

Financial Ratios-Meaning

It refers to a measure of the relationship between more than two components or even two components on the company’s financial statements. These ratios ensure that you can track performance easily, spot trouble, and proactively provide solutions.

Doesn’t matter if you move an inch or a mile, you record all the financial moves in your business accounting records. These ratios help to make sense of the accounting information in your company’s books. Ratios help identify and understand the aspects of the business that are efficient and also those that may not be working. These ratios also compare in order to know where you are placed against your competitors. It helps identify the profits or gains you made and the weaknesses.

In fact, lenders and investors use these ratios to judge the strength of the business. Therefore the Financial Ratio is a key performance indicator, or KPI as you would call it. These ratios only use the information that can be found in your financial statements audit.

The Significance of Measuring Financial Ratios

Undoubtedly, these ratios are essential for carrying out quantitative analysis. Few ratios are available to compute short- and long-term financial and operational performance. It finds out the trends in the business and shows warning signs or alerts when it is time to make a change.

Further, in case where the business wishes to have outside funding from an investor or a lender, these ratios provide those people with information on whether the business will be able to repay the money and yield a strong return on investment.

Usage of Financial Ratios

Financial Ratio is used in two different ways:

Firms’ Performance Analysis– This can be evaluated with trend analysis, computing an individual’s ratio on a per-term basis and tracing the worth over a period of time. The said analysis helps determine the source for pending receivables, its average collection duration and a decrease in the organization’s liquidity status.

Relative Performance Comparison– The comparison is made between the company’s profits with other competitors.

Important Financial Ratios

We have compiled 7 of the most important financial ratios you can track for your business.

Cash flow to debt

Most of the cash with a business is used for the purposes of debt repayment. Here cash flow to debt ratio can work wonders considering that weak cash flow is an impediment to success for many businesses, small ones in particular. Debt doesn’t seem like a huge liquidity problem until the due date arrives. You may have borrowed the money for your business-related purposes, but you may keep ignoring the fact that you need to repay the loan until the date for repayment arrives. Suddenly you find out that you don’t have the cash flow.

Here businesses can use the cash flow to debt ratio, which will help them to keep an eye on cash flow. It may be noted that the cash flow to debt ratio below one signifies that you may not be able to cover your bills without additional funds.

Net profit margin

This term refers to the % of your revenue that remains after deducting the operating expenses, taxes and interest. Various investors consider net profit margin as it signifies how successful a company is at managing costs and converting revenue into profits.

A poor net profit margin can indicate that there are a variety of problems that need to be attended to. One reason could be that the sales are decreasing because of the inefficient customer service. It may be a possibility that you are not keeping tabs on consumable office supplies, or it could be some other issue.

On the other hand, a high net profit margin shows that the products have been priced correctly and that you are exercising reasonable cost control.

Gross margin ratio

If the business deals with selling products, this is one crucial ratio that needs your attention. This ratio reflects the amount of money left with you to pay for the operating offences once you pay for the product you are offering.

This ratio may be measured by product or in total for the business. For instance, a clothing retailer’s gross margin can be measured by a product. The higher the gross margin, the more money you will have to pay for other business expenses. A low gross margin signifies that you might have difficulty paying off the operating expenses.

Quick ratio

Next is the quick ratio. This is also called an acid test. This ratio is helpful for businesses with current liabilities like accounts payable^[1], loans of short-term, payroll taxes that must be paid, income taxes that must be paid, credit card debt and other expenses.

The quick ratio measures liquidity and informs you if you have adequate current assets to cover your current liabilities. If the quick ratio is on the higher side, you are better placed. If your quick ratio is less than 1.0, your debts are more than your assets; therefore, you should pay off the debt and save more cash first.

It may be noted here that this ratio doesn’t include inventory in your current assets, as inventory might not be readily converted to cash.

Accounts Receivable Turnover

Accounts receivable turnover helps to know how well the company is being paid. Cash flow has been a concern for businesses, especially for small businesses. Being paid on time can help the company to feel confident in its cash position. If your account receivables turnover starts getting high, it shows that you need to spend time on the receivable process.

Inventory Turnover Ratio

The term inventory turnover ratio helps in knowing how many times inventory was converted to sales during a particular period of time. Thus it is helpful for businesses carrying inventory.

One can calculate it by month, quarter or by year. A high inventory turnover ratio means the business is regularly turning the inventory over. Companies having perishable inventory will have a relatively higher inventory ratio than businesses having more expensive or non-perishable inventory.

By computing the inventory turnover ratio, one can determine if they are wasting resources on storage costs or attaching the cash to a slow-moving or non-salable inventory. Many investors use this to determine how liquid a company’s inventory is, as inventory is one of the most significant assets a retailer reports on its balance sheet.

If the inventory can’t be sold off, it becomes worthless for the company. Creditors also use this ratio as the inventory is often marked as collateral for loans.

If you want additional financing for your business through an outside investor or a small business loan, consider looking at your inventory turnover ratio and improving the number.

Sales per employee

If a business’s sales per employee ratio are high, it signifies that the business is efficient in managing resources. This is a handy metric on which one can track for making an important business decision.

If a business’s sales per employee are growing, then such business is growing efficiently. If it is not, you need to check whether it is a temporary issue or if the business operations are not operating as efficiently as they need to or could.

Takeaway

From the perspective of financial ratios, one must understand that a company may not be evaluated appropriately through one ratio. Therefore you need to put a variety of ratios to use to make more confident investment decision-making.

Read our Article: Critical Financial Performance Ratios to Track a Start-up’s Liquidity, Profitability, and Solvency